Monetary-Fiscal Interactions and the Euro Areas Malaise Marek Jaroci - - PowerPoint PPT Presentation

Monetary-Fiscal Interactions and the Euro Area’s Malaise Marek Jaroci´ nski, European Central Bank Bartosz Ma´ ckowiak, European Central Bank and CEPR

“Next Steps for the FTPL,” University of Chicago, April 1, 2016 The views expressed here are solely those of the authors and do not necessarily reflect the views of the ECB

Research questions

• What is the relation between how monetary and fiscal policy interact in

the euro area and the macroeconomic outcomes? — Real GDP per capita at the end of 2015 was 2 percent lower than in 2008. — Inflation has been low and the ECB’s policy rates have been close to the lower bound. — Government bond spreads, about zero until 2009, increased sharply and subsequently

decreased to low levels.

• What kind of interaction between monetary and fiscal policy in the euro

area would improve macroeconomic outcomes?

This paper

• The current configuration of monetary and fiscal policy in the euro area

has been central to the recent outcomes. — We solve a simple, non-linear general equilibrium model with sticky prices. — The model mimics the recent euro area data.

• An alternative configuration of monetary and fiscal policy, with a non-

defaultable Eurobond, can lead to much improved outcomes.

Model

• A single economy, homogenous households and firms, households pay

lump-sum taxes to  fiscal authorities.

• The monetary authority follows an active rule subject to the lower bound.
• Fiscal authority  issues one-period nominal bonds, follows a passive rule

that includes feedback from output. — Defaults if debt exceeds an upper bound, the upper bound is an i.i.d. random variable.

Indeterminacy

• The model has two steady states: “intended” and “unintended” (Benhabib

et al., 2001).

• After a disturbance that decreases the value of current consumption there

are multiple solutions for { Π }=∞

=1 .

• There are multiple solutions for the interest rate on debt of fiscal authority

.

Baseline simulation

• A “confidence-about-inflation” sunspot can occur with probability  each

year so long as the shock has not occurred. — After the shock has occurred, the economy converges to the unintended steady state.

• A “confidence-about-debt” sunspot picks a solution for the interest rate
• n debt of fiscal authority .
• Fiscal authorities: “North” is GER, FRA, NED, “South” is ITA, SPA.

2008 2009 2010 2011 2012 2013 2014 2015 0.95 0.96 0.97 0.98 0.99 1

Output, Y 2008 normalized to 1

Figure 3: The baseline simulation versus the data

Data Baseline simulation

2008 2009 2010 2011 2012 2013 2014 2015

• 0.5

0.5 1 1.5 2 2.5 3 3.5

Inflation rate, 100(Π-1) Percent per annum Data, HICP Data, Core HICP Baseline simulation

2008 2009 2010 2011 2012 2013 2014 2015 0.5 1 1.5 2 2.5 3 3.5 4

Central bank interest rate, 100(R-1) Percent per annum Data Baseline simulation

2008 2009 2010 2011 2012 2013 2014 2015 0.5 1 1.5 2 2.5 3 3.5

Government bond spread, 100(Z2-Z1) Percentage points per annum Data Baseline simulation

Policy experiment: a centrally-operated fund issuing Eurobonds

• Ready to purchase debt of fiscal authority  so long as that authority

follows a prescribed rule.

• If  = 1, the monetary authority switches to setting an exogenous path

for  converging to the intended steady state.

• If  = 1, fiscal authority  switches to setting

˜  = ¯  + 

"

˜ −1 − 

ÃX



˜ −1

!#

+   ( −  ) where P

  = 1 (Sims, 1997). An active fiscal policy for the union as a

whole, implying a unique solution for { Π }=∞

=1 .

2008 2009 2010 2011 2012 2013 2014 2015 0.95 0.96 0.97 0.98 0.99 1 1.01

2008 normalized to 1 Output, Y

Figure 4: The policy experiment in Section 5.1 vs. the baseline simulation

Baseline simulation Experiment in Section 5.1

2008 2009 2010 2011 2012 2013 2014 2015

• 0.5

0.5 1 1.5 2 2.5

Percent per annum Inflation rate, 100(Π-1) Baseline simulation Experiment in Section 5.1

2008 2009 2010 2011 2012 2013 2014 2015 0.5 1 1.5 2 2.5 3

Percent per annum Central bank interest rate, 100(R-1) Baseline simulation Experiment in Section 5.1

2008 2009 2010 2011 2012 2013 2014 2015 0.5 1 1.5 2 2.5 3 3.5

Percentage points per annum Government bond spread, 100(Z2-Z1) Baseline simulation Experiment in Section 5.1

Default by a national fiscal authority

• If fiscal authority  deviates from the prescribed rule, the fund refuses to

purchase its debt and the authority can default. We use the model to assess the consequences of default.

• Splitting ˜

 = ˜ 

 + ˜



 between the fund and households:

˜ 

 = ¯

 + 

"

˜ 

−1 − 

ÃX



˜ 

−1

!#

+   ( −  ) ˜ 

 =  +  ˜



−1 +   ( −  )

• We suppose that South deviates by lowering ¯

2 and defaulting on house- holds, with recovery rate ∆ =

³¯



2

¯ 

2

´

.

2008 2009 2010 2011 2012 2013 2014 2015 0.98 0.99 1 1.01 1.02

2008 normalized to 1 Output, Y

Figure 5: The effect of default on the policy experiment from Section 5.1

Simulation without default, Section 5.1 Moderate default scenario, Section 5.2

2008 2009 2010 2011 2012 2013 2014 2015 1.4 1.6 1.8 2 2.2

Percent per annum Inflation rate, 100(Π-1) Simulation without default, Section 5.1 Moderate default scenario, Section 5.2

2008 2009 2010 2011 2012 2013 2014 2015 0.98 0.99 1 1.01 1.02

2008 normalized to 1 Output, Y Simulation without default, Section 5.1 Severe default scenario, Section 5.2

2008 2009 2010 2011 2012 2013 2014 2015 1 2 3 4 5 6 7 8

Percent per annum Inflation rate, 100(Π-1) Simulation without default, Section 5.1 Severe default scenario, Section 5.2

Conclusions from the simple model

• The current configuration of monetary and fiscal policy in the euro area

has been central to the recent macroeconomic outcomes.

• An alternative configuration of monetary and fiscal policy, with a non-

defaultable Eurobond, could have led to much improved outcomes.

Back to the research questions

• “What is the relation between how monetary and fiscal policy interact in

the euro area and the macroeconomic outcomes?”

• “What kind of interaction between monetary and fiscal policy in the euro

area would improve macroeconomic outcomes?”

• Much work remains, e.g., modeling country heterogeneity, adding debt of

different maturities, bringing the model closer to the data.